The Stock Market, Credit and Capital Formation

CHAPTER XVI

THE STOCK MARKET, EASIER CREDIT, DEARER CREDIT

101. Now that we have established that stock exchange loans are no more dangerous in their effect than other kinds of loans granted in the same volume, we must consider whether the volume of lending may not be influenced by the stock exchange, and whether this influence is not such as to tend to increase the total volume of credit.

The question we are asking here is the reverse of the one which we asked at the beginning. Our original question was whether lending to the stock exchange caused too little credit to go to industry. The question we are asking now is whether lending to the stock exchange may not cause too much lending, or whether “excessive speculation on the stock exchange . . . does not eo ipso produce an inflation.”1

Stock speculation, so much blamed for credit scarcity, is also accused contrarily of causing credit inflation.

Whether or not there is any sense or justification in talking about the “causes” of an inflation depends not only on the definition of the concept of inflation but also on the prevailing institutions. If inflation is defined as an increase in the effective circulation of money, it has a certain sense, and is methodologically legitimate, to refer for example to a certain improvement in the technique of payments as the “cause” of an inflation. Whether, however, it is also justifiable to talk about objective causes of an increase in the volume of money depends on the prevailing institutions. Under the institution of the gold standard there may in fact be a cause of a gold inflation in the sense of a causal nexus which is explicable in economic terms. Under the gold standard the discovery of new rich gold mines, or a technical improvement in gold mining, would have to be regarded as causes of an inflation. The increase in the volume of money would be the “necessary consequence” of the changes in the conditions of gold production. Under the type of monetary system, however, where the volume of the circulation is controlled by a central monetary authority there is nothing according to which the fact of an increase in the volume of money can be determined by reference to any proposition of economic theory. In this case an inflation is not the automatic or regular effect of objectively given facts, but is the result of a certain policy. There may be more or less obvious motives behind the policy; the policy may be easily rationalized; it may be explicable on ideological, psychological or teleological grounds; but an inflationary policy of this kind cannot be said to be governed by any causal necessity of the type discussed in economic theory.

It depends on the particular institutions whether or not there is any sense in seeking an economic “cause” of inflation.

There may be “economic causation” in the case of an “automatic” gold inflation—

—but none in the case of a “controlled” credit inflation.

If in any particular monetary system the issue of money takes place through lending by a bank which has a monopoly and is controlled by the state, then it is within the power of the administrators of credit policy either to grant credit or not to grant it. Their decision is not guided by the principle of maximizing the profits of the issuing bank, and is not therefore determinate in the sense of economic theory. The fact that at any particular moment requests for more credits or for larger credits may be made to the bank is under these circumstances no “cause” for granting these requests.

It would be different under a system of free banking where the issue of money was independent of political aims. If the reserves of a multiplicity of competing banks were dependent on nothing else but gold production and gold movements—and could not be increased or decreased by central bank policy—the situation would be such that an inflation would be explainable as the economic consequence of certain circumstances (such as gold production, liquidity preferences, demand for credit). When, however, the supply of credit is managed by a central authority, an inflation is not the result of economic behaviour such as the behaviour of the buyer, the producer, the trader or the saver, but the result of “intervention” just like any measure of tariff policy, labour policy or tax policy.2

One should distinguish between economic mass behaviour and economic policy.

The prevailing monetary systems in England and the United States are a compromise between political and economic determinants of the volume of credit. Many present-day students of monetary theory are inclined to exaggerate one or the other of these two aspects. Those advocates of an active trade-cycle policy who hold the official credit policy of the monetary authorities responsible for all fluctuations in investment and business activity exaggerate one aspect. Those members of the Keynes school, who regard an increase in investment opportunities as involving a simultaneous increase in money incomes, exaggerate the other aspect: they regard fluctuations in the demand for credit as the dominating “cause” of inflation and deflation. As I see it, the truth does not even lie exactly midway between these two views. I believe that inflation might be attributed more to political factors and deflation more to economic factors. The monetary authorities can do very little to avoid deflation; on the other hand they can avoid inflation by withdrawing appropriate quantities of reserves from the banks, so that the latter will not grant credit to the full extent to which it is sought under given conditions, or will grant credit only under more strict conditions.

The political and economic determinants of the credit volume might be evaluated—

—by reference to controllable and non-controllable factors.

Requests for credit come to the banks from many different sources. Since the granting of credit (apart from personal loans) is influenced by the security that the borrower has to offer, and since particular types of cover or collateral (bills of exchange, shipping documents, warehouse receipts, securities) have proved to be specially suitable for bank credit, it has often been supposed that the possibilities of granting credit were strictly limited by the available quantity of these kinds of “security.” In particular it was supposed for a long time that there was a strict dependence of the total volume of bills and requests for their discount on the “volume of trade.” It has frequently been pointed out that this is a mere superstition. The number of bills coming forward for discount is largely dependent on the credit policy of the banks. An increase in the demand for loans against bills can in principle just as well lead to a tightening of the discount market as to the granting of the loans. It all depends on the policy of the banks, or on their reserve position as determined by the policy of the central bank.

Whether or not an increase in the demand for credit and an increase in suitable collateral lead to more bank loans—

—depends upon credit policy.

Just as the desire to get bills discounted cannot be treated as the “cause” of the granting of the discount credit, neither can the request for loans against long-term securities be regarded as the cause of the granting of these loans. If the banks look upon securities with certain market values as sufficient cover for a loan of a certain figure, this does not mean to say that they are bound to give credit to everybody who can offer this kind of collateral. It may be argued against this that the banks are interested in lending as much as possible and will therefore be pleased to lend against the securities offered. The answer to this objection is that the banks are interested not merely in making profits on interest account, but also in protecting their solvency. The interest in increased lending is therefore only predominant when the official policy of the privileged central bank absolves the banks of the necessity of looking after their own solvency.

102. During the war there were people who described the inflation as the necessary consequence of the increase in prices. Those were unenlightened days, of course. But what are we to say about the argument that the rise of security prices is the cause of further inflation? Of course this statement is not meant to be taken too literally. There would be no objection to it if it were formulated more carefully somewhat as follows: “A rise in security prices may lead to the expectation of a further rise in prices. If corporations now take advantage of the public’s willingness to buy by issuing new securities, there will be a rise in the demand for loans against securities. Assuming that the central banks, through their credit policy, rid the commercial banks of the necessity of looking after their own solvency, then, if it is customary to consider securities as collateral for loans up to a certain percentage of their market value, the rise in security prices will lead to an increase in lending against securities.” This seems to be what is really meant when stock exchange speculation is described as the “cause” of the creation of bank credit.

Statements concerning stock speculation as a cause of credit expansion call for several qualifications.

We ought to consider here the question of the percentage up to which loans are granted against securities and the prices at which the securities are valued for this purpose. Let us assume that a margin of 55 per cent, is required (in the language of the American authorities3) so that 45 cents may be borrowed on every dollar’s worth of collateral. Any rise in stock values gives “more margin” to the speculator. It allows him to borrow another 45 cents on each dollar of paper profit. If this is done and the increased credit is used to purchase more stock, market values rise further; and this further rise raises again the margin for potential loans; more loans, more purchases, higher prices, wider margins, and so on, in a (for a time) self-perpetuating spiral.

Fixed loan margins based on the market prices of securities widen the basis for credit when stock prices advance;—

There are of course remedies against this so-called “pyramiding.” In 1929 Cassel proposed4 that the banks should “under normal conditions agree on a certain valuation of securities for the purpose of making loans” and should “refuse any increase in the former loan values in spite of the increase in stock prices” or should even decide on “a general percentage reduction of the loan values.” If rules of this kind could really be made effective in deterring the banks from expanding credit, they would undoubtedly represent a considerable step forward. But it is hardly to be expected that they would be effective so long as the precondition of credit expansion, an easy money policy on the part of the reserve banks (or large excess reserves resulting from a previous easy money policy of the monetary authorities) prevails.

—this can be avoided by fixing the loan valuations of securities.

In the United States the monetary authorities have felt themselves obliged to impose relatively narrow limits to lending against securities. According to the provisions of the Securities Exchange Act of 1934 the Federal Reserve Board can issue rules and regulations concerning the amount of credit that may be granted against securities. The fixing of invariable margin requirements which are based on the current market prices for securities does however create the undesirable “pyramiding” effect described above no matter whether the margin requirements are high or low. In order to avoid this effect the Federal Reserve Board in 1934 issued the following regulation: “A loan on a security must not be greater than whichever is the higher of: (1) 55 per cent, of the current market price of the security, or (2) 100 per cent, of the lowest market price of the security since July 1, 1933, but not more than 75 per cent, of the current market price.”5 For some time this regulation created an “anti-pyramiding zone”; soon, however, the prices of securities rose so high that only the first of the two rules was applied and the second one was therefore later revoked.

In the United States legal margin requirements are decreed;—

—for some time the formulæ attempted to create an anti-pyramiding zone”;—

The conclusions reached on the basis of an investigation by the Twentieth Century Fund, New York, contain the proposal that a maximum loan value of a share of stock should be fixed at some multiple of the net earnings of that stock over the five years preceding the loan.6 A rule of this kind would mean that the loan value would change little and only once a year. Increases in the market prices of shares would, therefore, not permit increased amounts of lending.

Another rather arbitrary method of dealing with the problem is to lower the percentage up to which credit can be obtained on the basis of a given market value of securities when the market values rise, and to raise it when the market values fall. The Federal Reserve Board seems to have decided in favour of this method: in January, 1936, when stock prices were on the increase, margin requirements were raised, and in October, 1937, when stock prices had collapsed, margin requirements were lowered. The lowering of the requirements came much too late, however, and the Board was severely criticized for that reason. “If this method of control is to be used, it should be . . . flexibly and promply applied.”7

—now they are manipulated to offset changes in security valuation.

The idea behind all these measures against an expansion of lending against securities is presumably that they will prevent the stock exchange boom from having “inflationary effects.” So far as the credit expansion in general is really restricted through such measures, they are appropriate to their purpose, and in many situations are fully justified. If, however, they merely serve to divert the stock exchange credits into other forms of credit creation, they accomplish nothing. This has been demonstrated in the previous chapter.

Such measures are effective in so far as they really check credit expansion.

If increases in security prices give the banks the opportunity to increase the volume of their lending against securities, it may look as though the stock exchange were the cause, and the expansion of credit the effect. If there exists a latent capacity and willingness on the part of the banks to extend more credit, then such a conclusion is admissible. To put the same thing in technical terms: When the supply of bank credit is perfectly elastic the demand determines the volume of credit granted. It is then a disputable point as to whether it is more sensible to say: “The increase in the demand for credit by speculators leads to the inflation” or “the perfect elasticity of the credit supply leads to the inflation.’’ Since the perfect, or practically perfect, elasticity of the credit supply is the result of political measures, I think there is little justification in the accusation that the blame for the credit inflation lies with stock exchange speculation.

If credit is inflated,—

—one must blame the elastic supply by the banking system, rather than the increased demand by stock speculators.

103. An idea connected with the problem of the influence of security transactions on the volume of credit is the supposed “duplication of credit” resulting from the system of financing capital requirements through security issues. According to this idea not only are the actual firms able to obtain credit: the owners of the titles (securities) to the property of those firms are able to obtain credit as well by using the securities as collateral for loans.8 Thus the capital value of the firm presumably serves twice as a basis for credit.

It has been asked whether the security method of finance did not permit “double-borrowing”: first by the corporation, then by the security holder.

It is certainly true that the security form of financing business has made it easier to borrow. But it is quite untrue to say that this has made possible a doubling of the basis of credit. When the owner of capital placed his money capital at the disposal of a firm, this was acknowledged in the form of shares or in the form of bonds. If for any reason he now desires to withdraw the whole or part of his money capital, he will look for another person who possesses free money capital to take over his title. This may take place either through the definitive or conditional purchase of the securities, or through a loan against those securities. Fundamentally the same process comes into play in both cases: the place of the first capitalist is taken by a second capitalist who provides the money capital invested in the undertaking. If the owner of securities borrows on them, this does not mean that the company which issued them and the owner who borrows on them have raised capital: all that it means is that the capital raised by the company has been provided partly by the owner of the securities and partly by the person who gave the latter a loan against those securities.

The company has raised capital by issuing securities; the investor raises capital by borrowing against the securities: this is substitution, not duplication of funds.

It would, however, also be possible for a firm to obtain additional credits (e.g., bank loans) besides the capital procured through the issue of securities, and for the shareholder at the same time to borrow on his shares. Does this not involve a duplication of credit made possible by the method of raising capital through the issue of securities? It is easy to see that this is not so once we realize that much the same thing can take place without the security form of finance. A partnership, N & Co., may secure a loan and at the same time Mr. N may be able to obtain a loan for his personal needs on the strength of his position as chief partner of N & Co. The condition for granting a personal loan of this kind will probably be that the lender considers Mr. N (perhaps on the basis of references and other information) as a credit-worthy person on account of the considerable volume of personal funds which he has invested in his firm. If, on the other hand, the firm is deep in debt, the partners will have a lower credit rating. The same applies, again, to the firm which has raised its capital by an issue of securities. If the corporation has, in addition, borrowed so much that the relationship of its borrowings to its share capital is considered to be unfavourable (and the high interest charges squeeze the dividends), then the shares of this company will fall in value and will give diminished possibilities of borrowing against them.

The company may, however, borrow additional funds;—

—but increasing indebtedness of the firm is reflected in a lower loan value of its shares.

As the level of indebtedness of the company is expressed in the price of the shares, and this price is accordingly only a reflection of the net worth of the company, the “credit rating” of the shares reduces itself to the portion of the capital which the company really “owns,” and does not make possible any duplication of credit. The fact that the capital of the undertaking is raised in the form of securities merely makes it easier to transfer ownership of the capital invested in it, and so enables the individual owners to liquidate their capital more easily and more completely. In other words, the security method of financing enterprises makes it easier for investors to use the titles to their capital as collateral for loans or to replace their own funds readily by the capital of other investors. In times of growing optimism, however, investors may be able to get more money capital loaned on their securities than the corporations have received when they issued them. This is the kernel of truth in the idea of the “duplication of credit” under the system of security capitalism.

Booming stock markets may allow the investor to borrow more against the securities than the corporations have raised.

104. We have already discussed the allegation that stock exchange speculation produces the temptation for the banks to expand credit and thus to cause an inflationary easiness of credit. No less deserving of attention is the opposite claim that stock exchange speculation causes credit, particularly industrial credit, to become dearer. This latter argument is not entirely disposed of by our investigation into the possibility of capital absorption. For it is quite conceivable that the stock exchange may not tie up capital either temporarily or permanently, and that, nevertheless, it may raise the price of credit (i.e., the interest rate) by bidding for it on the market.

Stock speculation was also accused of causing higher interest rates, even if it did not “absorb” credit.

It seems to me that it is precisely this point which has awakened so much practical interest in the whole of this group of problems. The borrower who had to pay a higher rate of interest at times of a booming stock market felt that his interests were harmed by the competition of the stock exchange.9 Practical business men were thus originally concerned only with the tendency towards a rise in the cost of credit. This was then connected up with the absorption of capital. Our study of this possibility has, however, given rather negative results, for we came to the conclusion that a tying up of “genuine” (i.e., non-inflationary) money capital on the stock exchange was extremely unlikely. We are thus brought back to the single point as to whether stock exchange speculation is the cause of higher interest rates.

105. The mere trading of securities, the exchange of ownership of already existing securities, is, according to George Halm, quite irrelevant from the point of view of the cost of credit. “The purchases and sales which take place on the market for credit titles . . . cannot exert any influence at all on the pricing of capital disposition. Of course, the conditions of demand and supply of the particular categories of credit titles may change. But the supply and demand conditions for capital disposition do not change in the least.”1 According to this view the rate of interest is one of the factors determining the price of securities, but the interest rate is not in turn dependent on the level of security prices. The value of securities is calculated as the capital value of the expected return, and is thus the result of so-called capitalization, which combines the two factors—the return and the capitalization rate. If the expected return and the capitalization rate are given, then, allowing for a risk and uncertainty premium, the price of the security is also determined. If the yield prospects or the capitalization rate change, then the security prices will also change. But the latter are to be regarded as the dependent variable in this relationship.

Can the change of ownership of existing securities affect the price of credit?

Security prices are said to be dependent on, or even to imply, the rate of interest; the latter being the independent variable.

The foregoing description is, however, a very much simplified one which leaves many factors out of account. In the first place we have been talking about the capitalization rate, whereas in fact there are a number of different interest rates. Furthermore, we referred to the expected yield, while in fact there may be sharp divergencies between the yield estimates of different individuals in the market. Lastly, the rate of interest and the yield prospects were regarded as data with respect to which no changes were to be expected in the near future. The introduction of these complications of reality make many qualifications necessary.

According to Halm the capitalization rate on the securities market is the result of two components—the “static long-term rate of interest” and the “money market rate.”2 This is perfectly correct, although the definition and measurement of the “static long-term interest rate” remain unsolved problems. Strangely enough, however, it is the effect of the “money market rate” on security prices that has been cast into doubt. An investigation of Richard N. Owens and Charles O. Hardy has sought to show that the money market rate had no influence on security prices.3 The final conclusions derived from 111 pages of text and an ample appendix are that the theory of the influence of the money market rate on security values is false, because the costs of buying and selling securities usually “eat up” any gain from the difference between the interest rates; that interest plays no rôle relative to the profits derived from changes in security prices; and that the speculator does not require any capital whatsoever for his transactions.4 These are not very serious objections. Certainly the expenses are a consideration and the height of commissions and sales taxes represents an important friction. The important thing is, however, the size of the difference (between the money market rate of interest and the yield on securities) and the expected duration of the rate level on the money market. Admittedly the interest charge does not play a very large rôle in connexion with the profits derived from changes in security prices. It is important, however, not to confuse security prices with changes in security prices. It is a fact that a speculator who expects a considerable rise in security prices will hardly be deterred by a high interest rate. The existence of an influence from the side of expected price changes on the interest rate is, however, not at all incompatible with the existence of the influence of the interest rate on security prices.5

Others have questioned the effect of interest on security price,—

—on the ground that the cost of trading exceeds the gain from interest spreads,—

—and that interest charges are trivial as against gains from security price changes.

One should distinguish between security prices and expected security price changes.

The influence of the money market rate on the securities market cannot be seriously contested. Not only the rise of security prices during periods when the money market rate remains for a long time below the “static long-term rate,” but also the sharp break in the speculation curve when the increased money market rates finally lead to a higher capitalization rate, are far too striking phenomena to be covered up in statistical series.

Exactly what is meant when it is said that the interest rate influences security prices, but that security prices do not influence the interest rate so long as no changes take place in the supply of, or demand for, money capital, can best be explained by the aid of an example.

Let us assume that the dividend prospects of the companies A, B, C, and D are estimated at 8, 6, 5, and 4 dollars respectively. In order to simplify the mere arithmetic of our example we may assume that these dividends are regarded as permanent—as perpetual annuities—and we shall also abstract from considerations of risk and uncertainty. If it is possible to obtain loans at 4 per cent., and no change is expected in this respect either, then under the given assumptions the securities market will set values of 200, 150, 125, and 100 dollars on securities A, B, C, and D respectively. Now suppose that the yield prospects of the D shares rise from 4 to 5 dollars. If this is generally known and is expected with certainty, then the value of the D shares will rise from 100 to 125 dollars, no matter whether there is any actual turnover of security titles or not. The interest rate of 4 per cent, will not be affected. If the improvement in the yield prospects is known only to a few speculators, then it will pay these people to borrow money to buy D shares at any price between 100 and 125 dollars. But even this demand for funds will not raise the interest rate or will only do so for a few hours, since as soon as the purchase of the securities is effected, a supply of credit will be forthcoming from the side of the seller. On a well-organized market the seller may lend to the buyer—and the increase in the price of the shares will come about without any increase in the interest rate.

An illustration is given—

—which shows that better prospects may raise prices of existing securities without raising interest rates.

106. The matter is different if the D company, in view of the increased profitability of its business, wishes to expand its production. If the acquisition of the necessary capital is to take the form of an issue of shares, the new shares will perhaps be issued at a price of 120 dollars. Here—where there has been a rise in the price of the shares from 100 to 120 dollars—the credit market will be altered by an effective demand for new credit, and if the supply of credit is unchanged (and if it is not perfectly elastic) the raising of capital by the company will lead to a rise in the interest rate. This rise then appears to have been induced by the securities market, but it has in fact been caused by the demand from industry.

If, however, new securities are issued by industry, interest rates may rise.

It is this peculiar misunderstanding which has led to the attempt to construct an antithesis between industrial credit and the securities market. In actual fact it is the securities market on which industry raises the bulk of its capital requirements. Only a relatively small part of the capital requirements of industry is obtained by direct borrowing from the banks; it is called “industrial credit” by the latter: evidently the reason is that it is only in these cases that the name of the industrial undertaking appears on the bank’s books. In the case of advances where the account is held in the name of the industrial firm, in the case of discount credit where the firm’s name is written on the bill, and in the case of documentary credit where the name is written on the documents, the banks assume that they are lending to industry, whereas in the case of loans against securities, brokers’ loans, loans at short notice, and call loans the other parties to the contract often seem to be speculators in securities. In fact, however, the securities exchange is the chief market for industrial credits. “For industry as a whole industrial credit which is in the form of shares and bonds is the most important part of the credit which is really decisive for industrial development.”6

Not direct loans to industry, but the securities markets furnish the bulk of industrial capital.

Once we have recognized that the investment titles of industry are traded on the stock exchange, we are bound to see a speculative upswing of security prices as a cheapening of industrial credit. “Viewed from the standpoint of industry . . . the stock exchange boom implies a decline in the real rate of return’ on securities and acts, therefore, only as an improvement in the facilities for obtaining capital.”7

Higher security prices mean cheaper capital for industry.

The argument that the passage of capital over the stock exchange is “costless” is a view which has been put forward in particular by Cassel. Against this argument Reisch has attempted to prove that the stock exchange leads to an increase in the cost of obtaining capital. The purchaser of shares, Reisch argued,8 is willing to concede a high interest rate in the hope of making profits on changes in security prices; it is therefore improbable that the seller of the shares will place his proceeds at the disposal of industry at a low interest rate. Evidently the seller of the shares is here looked upon as lending money to industry; in reality, however, industry itself is a seller of shares. The more the buyer pays for the shares, the more cheaply does industry obtain the capital it requires. As Reisch speaks, at a later stage in his exposition, of industrial over-investment as the result of the stock exchange movement, he implicitly recognizes the reduction in the cost of obtaining-capital. For the lowering of the cost of obtaining capital which is reflected in the high prices at which new issues can be placed, or at which old holdings of securities can be realized, makes it possible to undertake extensive new investment.

The boom on the stock exchange undoubtedly involves a cheapening of industrial credit. The cheapening which took place in the United States in the years 1927-29 was, in my opinion, “unnatural” in the sense that it was the result of an inflationary expansion of credit.9 Against this view, Lindley M. Fraser holds that “the stock market boom . . . was in essence a natural reaction to the general economic conditions.”1 The supply of voluntary savings was so great, according to Fraser, that, with the rather inelastic industrial demand for capital, it could only be invested through a sharp rise in security prices, i.e., a cheapening of credit. Hence Fraser criticized the view “that speculation was making money too cheap for producers and entrepreneurs. No doubt that is a sounder view than either the doctrine that a stock market boom has no practical effect on industry at all, or—still more—the popular belief that it tends to deprive ‘legitimate business’ of the credit to which it is entitled.”2

Most writers agree that industrial credit during the twenties was exceedingly cheap, and that this was due to inflation—

—rather than to increased genuine saving.

Fraser thus agrees with me that the stock exchange boom brings cheaper credit to industry; he insists merely that industrial credit in the United States towards the end of the twenties was not unhealthily cheap. There can, of course, be no proof of either view; the figures of bank deposits and their velocity of circulation do, however, I think, speak against Fraser’s view.

107. Anybody who speculates on the rise in the price of a security is prepared to pay a higher interest rate for direct credit than he actually obtains in the form of dividends on his security. This difference partly explains the cheapening of the security form of industrial credit. When industry receives the new (cheap) capital and/or when the seller of shares withdraws from the stock market with his profits, call money rates rise. The rise in call money rates3 also brings in its train, however, a rise in discount rates and rates for other kinds of bank credit, and anybody who requires credit in this form has to submit to a rise in its price.

The rise in call money rates which accompanies the stock market boom usually leads also to higher rates for other forms of bank loans

It might be argued that industry will react more markedly to a change in the costs of carrying working capital (financed by discounts or bank advances) than to movements in the costs of long-term credit, especially as existing industries do not usually have to take account of fluctuations in the rate of interest on the capital market. Their requirements of long-term capital are usually covered once for all, and a fall in the capitalization rate and a rise in the price of their shares is of less interest to them than their current payments in respect of short-term loans. Thus industries which have no intention of raising more long-term capital complain about credit becoming dearer, and it is such complaints that have led to the mistaken assumption that industry has to compete with the stock exchange for credit whereas what really happens is that long-term credit competes with short-term credit.4

It is, finally, industrial long-term credit which competes with industrial short-term credit.

So far as industry, which complains of the high rate of interest charged by the banks, has covered its permanent working-capital requirements by short-term loans, it is provided, by the situation of which it complains, with an excellent opportunity for financing its capital requirements in a more solid way and converting the “dear” bank credit into cheap long-term credit by increasing its capital stock. So far as periodic temporary capital requirements are concerned, it is questionable whether industry is seriously vulnerable in respect to the rise in short-term rates. Where the capital requirements of a firm fluctuate, the deplored movement of interest rates changes the “capital optimum,”5 making it profitable to raise more capital at long-term. The complaints of industry about credit becoming dearer are thus directed only in appearance against stock exchange credit; they are in reality directed against competitors in industry who have access to the cheap long-term capital.

This judgment may seem to be unjustified to the extent that industry is not exclusively composed of joint-stock companies for whom alone the way is open for obtaining capital on the securities market. Aside from the fact that the greater part of industry is financed by issues of securities and that single ownerships and partnerships constitute an almost insignificant part, even these types of business firms have ways of raising capital which correspond to the issuing of shares, viz., the taking on of new partners or members. The moment is not always favourable for such firms to find new associates. At the time of the crisis or during the depression few people will be interested in putting their money into a private firm, but the same thing applies at such times to the issue of shares. In the recovery phase or the beginning of the boom, interest reawakes first in fixed interest-bearing securities (debentures, bonds, mortgages); and as the stock exchange becomes more active industrial companies are able to proceed to issue shares, and good private firms are able to find new active or sleeping partners.

Are the cheap long term funds available to corporations only?

In times of booming securities markets new associates are easily found for partnerships.

If the supposed antithesis between stock exchange credit and industrial credit is non-existent, and all that exists are different forms of industrial credit which have more or less drawing power at different times, it may be justifiable to look upon other classes of would-be borrowers as injured. This may apply in particular to agriculture. It is a fact that agricultural credit becomes dearer in times when there is an active interest in industrial securities. Agriculture’s competitor for credit is industry and not “stock exchange speculation.”

Agricultural credit, however, becomes dearer with a booming stock market; it is then, industry which is the actual competitor for the credit supply.

108. There is another problem which is both narrower and wider than the question of the effect of stock exchange loans on the interest rate. This is the question of the effect of stock exchange loans on the lending capacity of the banks. It has sometimes been presumed that stock exchange loans decreased the lending capacity of the banks both absolutely and relatively. So far as concerns loans to brokers from other sources than the banks, this view of the diminished lending capacity of the banks is the reverse of the truth. The loans “on account of others,” which could be made by the banks in the U.S. prior to 1933, reduced the direct loans and the demand deposits of the banks and thus increased their excess reserves.6 To be sure the banks had to be careful since they knew that they must be prepared to step in and extend credit to brokers on their own account in case the “other” lenders should demand repayment of their loans. In this sense the loans to brokers by “others” released less bank credit than would otherwise have been the case.

Stock exchange credits may affect the leading capacity of banks.

Loans by “others” may release bank credit.

As regards the direct loans by the banks to brokers, these reduced the remaining lending capacity of the banks no more and no less than any other form of credit. Benjamin M. Anderson observed, quite rightly, that: “An increase in commercial bank loans of whatever kind, whether stock market loans, commercial loans, real estate mortgage loans, or loans of any other kind, tends to reduce the ability of the banks to make other loans, and tends to raise rates of interest to other borrowers. The point is that when a bank makes a loan, it must either pay out cash from its reserves, reducing its ratio of reserves to deposits, or else increase its deposits, which again reduces the ratio of reserves to deposits, though at a less rapid rate.”7

So far as I know, it was never denied that loans to brokers diminished the capacity of the banks to grant other loans. It would, however, be wrong to infer that lending to the stock exchange deprives industry of credit, for with few exceptions stock exchange credit is really industrial credit. Strangely enough, B. M. Anderson was numbered among the adherents of the hypothesis of capital absorption by the stock exchange.8 What Anderson really said when he made the above remark was, however, nothing more than that a loan which has already been granted (e.g., to industry in the form of stock exchange credit) does, of course, decrease the banks’ capacity to grant further loans.

Brokers’ loans by banks compete, of course, with other forms of bank loans.

109. Does the stock exchange cause credit to be dearer? This question, we have seen, has little point. The securities exchange is a part of the credit market; it is the market for credit which is long-term in character but can be easily realized. Is it possible that the existence of a market can increase the price of the thing that is traded on that market? It is easy to see that every increase in the supply of credit on this part of the market means a cheapening of the particular kind of credit that is traded on it, and it is equally clear that if the total supply of credit remains unchanged the credit dealt with on the other parts of the market must become dearer. Direct credit thus usually tends to become dearer as a result of the competition of the security form of credit when the former has been cheaper than the latter; this may be explained in terms of the tendency of the interest rates on the two partial markets to approach each other, and we refer to this as the closing up of the gap between long-term and short-term credit. It is one of the many paradoxes of those who are responsible for framing economic policy that they strive to obtain a diminution or a removal of the gap in interest rates on long-and short-term money respectively and at the same time complain of the increase in the price of short-term money which often is the necessary consequence of this process.

Stock exchange credits may make long-term credit cheaper and short-term credit dearer—

—and, thus, lessen or close a gap between the respective rates of interest.

The gap between the (low) rate on the money market and the (high) rate on the capital market may in principle have three causes:

The gap between a high long-term rate and a lower short-term rate may be due to—

1. The appearance of an increased demand for long-term capital which tends to raise the rate on the capital market. Such a demand for capital finds expression in a new security issue or in the unloading of unsold holdings of previous issues. The increase in the rate of interest on the capital market appears in the form of a decline in security prices.

—an increased demand for long-term funds;—

2. The witholding of the capital supply from long-term investments (following a crisis) which raises the rate in the capital market and lowers the rate on the money market.

—or reluctance to make long-term investments;—

3. The appearance of an increased supply of short-term capital which causes the money market rate to fall.

—or an increased supply of short-term funds.

In all these cases, sooner or later, a movement towards equilibrium will set in, tending to wipe out the difference. The increase in the price of direct bank credit through an increased volume of funds going to the stock exchange is in every case an essential element in this equilibrating movement.

Is it possible that loans to the stock exchange may cause the price of direct bank credit to rise above the rate of interest on the capital market? This is least likely to happen when the gap between the (originally lower) money market rate and the (originally higher) capital market rate was exclusively due to the first two of the three principal causes. For as soon as the yield margin is removed the demands of the “stock exchange” on the money market will cease. The closing together of the money market rate and real yields will have removed the cause of the tendency for bank credit to become dearer.

The low of money market funds to the securities markets may be the balancing factor.

If the first-mentioned causes are accompanied by the third-mentioned cause, then the case is different. If the gap between the interest rates is partly caused by an abundance of funds on the money market, this usually inflationary supply of credit may eventually lead to a cumulative movement which may in its later stages drive the money market rate up above the capital market rate. The funds which are offered on the money market may originally have come from current new savings or current depreciation funds and may have been withheld from the capital market because of lack of confidence (cause No. 2). As soon, however, as these funds begin to flow over into the capital market, the inflationary sources of the supply of funds to the money market (hitherto idle cash balances and newly created bank credit) will start flowing very freely. The great elasticity of this supply allows the cumulative upswing to attain such a speed that it does not stop at being an equalization process which would come to an end with the decline in the capital market rate (i.e., with the increase in security prices) and the rise in the money market rate: instead of this it develops into a boom with excessive financial and real investment. The capital market rate (i.e., real yields) is pressed down by the feverish expectations of further rises in security prices, and the money market rate is driven up by the demands for credit for the excessive extension of production. True, it is the stock exchange on which the producers’ demand for credit manifests itself; but to blame the loans to the stock exchange for the fact that credit becomes dearer is to refuse to go below the surface of things.

If the money market funds spring from inflationary sources, a cumulative movement may emerge—

—which concludes with the short-term rate above the long-term rate.

If we reason closely, the explanation of the fact that bank credit can become so much dearer has to go back to the fact that bank credit has originally been too easy. Stock exchange credit does not here play the rôle of the ultimate cause.

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